Waiting for the Ship to Reverse Course

What level of employment growth will it take for commercial real estate fundamentals to improve significantly? We recently put that question to our readers. The top answer: nonfarm payroll employment needs to grow by 200,000 monthly (see chart). By that measure, the February employment report came up way short, posting a net loss of 36,000 jobs. But it's better than expected, the experts tell us.

Sooner or later the jobs market will have a breakout month, but for now we'll have to settle for “better than expected.” If nonfarm payrolls rise by even 100,000 per month, it would do wonders to cheer up people, says Bob Bach, chief economist for brokerage Grubb & Ellis. “People would start to look forward and begin to contemplate a housing purchase, or some other purchases that maybe they have deferred. There is some pent-up demand that's developed in terms of retail sales.”

Housing headwinds

The recovery remains fragile. About 7.7 million homeowners are behind on their mortgage payments, according to Grubb & Ellis, and more than 4 million are delinquent and going through foreclosure. “This will be a destabilizing force on housing prices and add to the shadow supply of rental units,” according to Bach.

That's not encouraging news for the apartment sector, which has already experienced a significant deterioration in occupancy and rents. The national apartment vacancy rate reached 8% in the fourth quarter of 2009, according to Reis. That's the highest vacancy level on record since the real estate research firm began tracking the apartment market nearly 30 years ago. At the end of 2009, effective rents were 2.9% lower than at the end of 2008.

A rise in interest rates also could put a crimp in housing demand. The Federal Reserve is scheduled to complete its purchase of $1.25 trillion in mortgage-backed securities by the end of March, a program that has helped keep mortgage rates low. The average rate on a 30-year, fixed-rate mortgage today hovers right around 5%.

Cleaning up the mess

The commercial real estate sector's woes will be with us for some time. History shows that when a wave of distress strikes, it can take several years to dispose of the problem. The Resolution Trust Corp. (RTC), which was formed by the federal government in 1989 to liquidate insolvent savings and loan institutions, wasn't dissolved until 1995. By that time the RTC had closed or reorganized 747 institutions and managed to sell off some $400 billion of troubled assets.

“That was really an efficient way of selling those properties back into private hands,” says Bach. This time around we don't have an RTC. It seems like the Fed and the regulators are intentionally delaying this [disposition of assets] because they are much more concerned about the overall financial system.”

While it has become fashionable to bash the federal government on an array of issues, most notably its handling of the banking system, Bach believes the criticisms are excessive and largely unfair.

He gives high praise to the federal government for rescuing the U.S. and global economies as well as the financial sector. “ I think government pulled us back from the precipice. I think the [$787 billion] stimulus package had something to do with it and all the programs the Fed enacted.”

Inflection point

Much like the stock market, commercial real estate is a forward-looking industry. The decision on whether to buy, sell or hold an asset is driven in large part by where investors think the market will be a year or two from now.

The current national office vacancy rate is 17.4%, according to Grubb & Ellis. Even if it takes the sector four or five years to get back to equilibrium, an uptick in leasing activity will occur much sooner. Tenants will make their move when the vacancy rate starts to recede, says Bach. “They will say this is the time to make a deal because the market is going to tighten.”